The simplest explanation you’ll find: The chart that has the French financiers shitting themselves
It’s a bit technical but here is the chart that illustrates the whole issue with the French debt and threatened downgrade. It compares side by side the trading values of the US and French Credit Default Swaps (CDS).
Whilst the maths and probabilities sitting behind this are quite arcane, the concept overall is actually quite simple. It’s like your car or house insurance. The difference is that we are talking about insuring the countries’ debt instead of your apartment.
The CDS shows the cost of insuring US and French sovereign debt against default. Exactly in the same way your insurance premium (the price you pay each month or year) shows the cost of insuring your car from crashing. If you drive a sports car (very fast) and you are very young (inexperienced driver) you are more risky and will probably pay more than a family father driving an average automobile, who is supposedly less at risk.
Countries Credit Default Swaps work basically the same.
At the moment France’s 5-year credit default swaps are trading at around 160 ‘basis points’ (or 1.60 percentage points) meaning that it costs an average of $160,000 a year to insure $10 million of debt issued by France. In comparison the US CDS is around 50 basis points. The insurance is cheaper for the US than the French debt.
It also means that the probability that the French default on their debt in the next 5 years is higher than the US. To be precise, the calculation shows that the French have a 2.2% of defaulting over the next 5 years. If the numbers are to be trusted this is not insignificant, especially for a supposedly risk-less country (you remember the story.. the super safe Euro zone, the AAA rating, etc).
This is why people are scared. The trouble is that this CDS insurance price set by ‘the market’ is now at odds with the ratings set by the Agencies. Indeed, France is still rated AAA whereas the US are rated lower at AA+. So according to Standard & Poor’s France is still less risky than the US. Exactly the opposite of what the CDS price determined by ‘the market’ indicates.
So who is right? ‘The Market’ or Standard & Poor’s?
Because we live in a realm where we believe the ‘the market’ is always right, rating agencies are getting increasingly likely to downgrade the French debt. This is what has the Gallic financiers and Sarkozy’s government shitting themselves, and in an ironic feedback loop, the global financial markets with them.
leLaissezFaire, Sydney, 11 August 2011
References:
The Wall Street journal: http://online.wsj.com/article/SB10001424053111904007304576496263949498784.html
US CDS: http://www.bloomberg.com/apps/quote?ticker=CT786896:IND
French CDS: http://www.bloomberg.com/apps/quote?ticker=CFRTR1U5:IND
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Rating debts is about confidence in the borrower to pay back his debt in due time, in the mid term at least. Buying on liquid markets, cds or anything esle, is about betting on what other agents will do in a term that is getting shorter and shorter.
Of course, longer term trends are a sword of Damocles above the market players. They know it should drive positions in the mid term.
Meanwhile, in the short term, the only question is ‘can I take the risk to follow the latest trend and not be the last one to do so when trend switches?’. Or ’should I be among the first to bet on the flip to come?’
Short term hedging is simple enough for machines to do it. All you need are threshold and latency. Optimization makes it much complex but the principle remains the same.
In short term financial markets, you are buying when prices are increasing. You are not looking for a bargain to acquire goods but for another buyers to resale and make a profit on the transaction.
The best way to find an ultimate acquirer is to buy first, and make prices go higher. It should work until thresholds are crossed.
Such system is unstable. Not far from hysteresis i’d say.